The Number That Ends This Cycle…Part 2: Goldman Sachs Makes Its Choice

Everyone seems to agree that if interest rates keep rising a recession and equities bear market will ensue. But no one knows where the breaking point is in terms of, say 10-year Treasury yields. So it’s become a topic of debate with a lot of heavy-hitters offering opinions. Yesterday Goldman Sachs weighed in:

David Kostin, Goldman’s chief U.S. equity strategist, wrote in a note Friday investors should not worry about rising borrowing costs and their effect on stock valuations until the 10-year Treasury yield zeroes in on 4 percent. The benchmark yield traded at 3.07 percent on Monday.

“A rise in interest rates should lead to a fall in equity prices, all else equal. An equity’s value is equal to the present value of a perpetual stream of future dividends, which are highly sensitive to the discount rate,” said Kostin. “However, lower equity prices are not an inevitable consequence of higher interest rates. We expect negative valuation changes if the level of rates approaches 4%.” He also said stock prices could take a hit before that level is reached if rates rise too rapidly.

Yields have been rising as investors fear that inflationary pressures in the U.S. will lead the Federal Reserve to tighten monetary policy at a faster pace than expected. The 10-year yield hit 3.11 percent last week — its highest level since 2011 — while the two-year yield hovered around a near-decade high.

“The actual impact of interest rate changes on equity prices depends on the reason interest rates are rising. If interest rates rise in anticipation of faster economic activity, this could lift growth expectations and also lower the equity risk premium,” noted Kostin.

The 10-year yield had risen about 71 basis points year to date through Friday, Kostin points out. Stocks, however, have weathered the sharp rise in yields thus far. Entering Monday’s session, the S&P 500 and Nasdaq composite were up 1.5 percent and 6.5 percent for the year, respectively, while the Dow Jones industrial average is flat. The small-caps Russell 2000, meanwhile, hit an all-time high last week and is up 5.9 percent in 2018.

Here’s the take-away from Goldman’s perspective: “The actual impact of interest rate changes on equity prices depends on the reason interest rates are rising. If interest rates rise in anticipation of faster economic activity, this could lift growth expectations and also lower the equity risk premium.”Well, maybe. But this time around it’s unlikely that rising rates and a strengthening economy can co-exist for very long because of the unprecedented amount of variable-rate and/or short-term debt that’s out there. Governments around the world have borrowed at the short end of the yield curve to get historically low rates (Japan and Switzerland, with negative short term rates, actually lower their budget deficits when the borrow in this way), which means they have a ton of paper to refinance in any given year. As rates rise, the cost of the new debt that replaces the old goes up. The faster rates rise, the bigger the hole blown in government budgets. The mortgage market is already feeling the effects of the past year’s rate increase, with 30-year fixed loans nearly a full percentage point higher. One explanation for the minimal supply of houses on the market is that exiting homeowners have lower-rate mortgages than they’ll be able to get if they sell and buy something else, so why sell?So the net impact of rising rates will be more severe than ever before, which will change the “anticipation of faster economic activity” to “fear of a slowdown” in very short order. For stocks, this combination of interest rates that exceed their dividend yields and a rising likelihood of negative economic surprises will be potentially devastating. One other thing that can be said with certainty about rising rates is that they represent a shift of resources away from borrowers and towards savers, something that in moral terms is long, long overdue. For most of the past two decades, savers have been impoverished by miniscule rates on bank CDs and government bonds, while borrowers have been living in refi paradise, seeing the cost of their debts drop steadily. That is not a good world for people trying to build capital the old fashioned way. So a world in which the ants benefit at the expense of the grasshoppers would be a nice change.

If you know the other and know yourself, you need not fear the result of a hundred battles.

Sun Tzu

We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.